Introduction
You find yourself between the devil and the deep sea when faced with the dilemma whether to invest your money or save it in cash. On the face value, savings provide you with a buffer against any recession. But in fact, the value of savings keeps falling due to ever increasing inflation. On the other hand, investment comes with its own risks, which are actually more serious than the devaluation of your savings. You can lose all your money in an investment. The solution lies in distribution of your savings in such a way that the risk is minimized and the likelihood of earning is increased.
What is Asset Allocation?
There is a common saying: “Do not put all your eggs in one basket.” For if the basket falls, you lose all your eggs. Applied on finance, the saying becomes all the more valid. A wise investor is never fully exposed to risk-on assets like cryptocurrencies. They will allocate 60%-70% money to relatively safe asset classes like stocks and bonds. The crypto market, in addition to making your investment many X’s, can deprive you of all your investment. Therefore, you should invest only that money into cryptocurrencies which you can afford to lose because the crypto market runs on speculation. Even the safest cryptocurrency, Bitcoin, is subject to very high volatility.
The allocation of your assets as mentioned above is not hard and fast. It depends on the overall market conditions and also the conditions outside the economy. For example, black swan events like wars cause the value of safe assets like gold to rise exponentially. Risky assets get the hit and devalue. However, peace times foster risky assets to flourish against gold and treasury bonds.
Strategic Vs Tactical Asset Allocation
The distribution, or allocation, of assets falls in two distinct groups: strategic and tactical. Strategic allocation is a conventional form of asset allocation best suited to those who want to build a passive portfolio which rarely demands rebalancing. Tactical asset allocation demands active rebalancing. Following this strategy, you can take profit from a high-performing asset and shift your investment to a low-performing option, hoping that the latter will pump and multiply your gains.
Modern Portfolio Theory
In 1952, the Nobel Prize in Economics was awarded to Harry Markowitz for his groundbreaking Modern Portfolio Theory. In his paper, he demonstrated with mathematical models how diversification can best be achieved. He also stresses the fact that some market conditions favour one asset class and militate against the other. If your investment is optimally distributed, your loss in one area will be cut by the gains in another asset class.
MPT and Cryptocurrency
When you apply MPT to the cryptocurrency market, you learn how to distribute your investment into different uncorrelated narratives. Over exposure to one narrative will count under diversification. Similarly, choosing too many coins is considered over diversification. Over diversification leads to a poorly managed portfolio. You are unable to monitor all the coins efficiently.
However, the term “uncorrelated” may not apply as conveniently to cryptocurrencies as it does to the stocks, bonds, indices, metals and futures. Your research on and analysis of an altcoin may fail drastically when $BTC corrects or crashes. It is very rare that $BTC’s movement leaves the whole cryptocurrency market unaffected. Usually this can happen when $BTC dominance is falling significantly, which indicates that the capital is rotating from Bitcoin into smaller coins.
Diversification in a Cryptocurrency Portfolio
Zooming into a model crypto portfolio, you need an appropriate distribution of the coins with different risk-reward ratio. Generally, 60%-70% of your assets should go to Bitcoin alone. Allocate 15% money to large-cap altcoins. Mid-cap altcoins deserve 10% and only 5% should go to the low-cap coins. Unless you consider this technique, you are vulnerable to falling prey to greed and being over exposed to mid and low caps, thinking that they can multiply your investment more easily. But this approach shows poor risk management and defective diversification acumen.
Diversification within Altcoins
Not all of the 15% mentioned allocation should be poured into $ETH, $XRP or $SOL. The top 20 coins come into the orbit of large caps. You can select 4 or 5 coins on the basis of strong technicals or fundamentals.
Also, coins belong to different categories, depending on the use case, chain, or layer. Within large caps, you can choose one layer-1, one layer-2, one meme coins, one DeFi, one oracle, one AI, etc. These categories are generally mentioned in the info section of a coin on any exchange.
Stablecoins’ Portion in Your Portfolio
Outside the cryptocurrency market, a portion is necessarily allocated for cash. In a crypto portfolio, the cash portion may be assigned to stablecoins like $USDT, $USDC or $FDUSD. These coins are pegged to USD, so there is no volatility involved. The only risk is that they can be depegged unexpectedly, but such incidents are fortunately few and far between. The last time it happened was in May 2022 when $UST failed the investors and caused the linked coin $LUNA to fall from $119 to zero.
Rebalancing of Portfolio
The next step is that of rebalancing. As is already mentioned, monitoring of the portfolio is as important as building one. This is possible only if the number of coins is not too large. You need to sell the underperforming coins and shift the investment to the ones that are still dormant. This approach can help you boost your profits.
Conclusion
To conclude the discussion, your investment in the cryptocurrency market is at risk in many ways. Apart from volatility, the correlated nature of coins poses additional threat of collective dump. But you can try to minimize the risk by allocating a lion’s share of your investment to Bitcoin. Large-cap and mid-cap coins are the next suitable destinations of your assets. Small caps must be looked at with considerable caution as they are tantamount to the neck or nothing. Moreover, you should try to choose various categories and narratives while choosing coins for your portfolio. Finally, do not forget to rebalance to maximize your gains.
